The world of investment trusts

Published by Sonia Speedy on 11 December 2007.
Last updated on 25 August 2011

Picture of world within a set of cogs

The investment trust is considered an underdog in the investment world, often overlooked in favour of the sexier, more heavily marketed unit trust. Take a closer look at this investment vehicle, however, and you might be pleasantly surprised. But what is an investment trust?

"Investment trusts are a company like any other, with a fixed number of shares and a board of directors representing shareholders' interests," says Job Curtis, director of the value and income team at fund management firm Henderson Global Investors.

The difference, however, between an investment trust company and a normal company, like BT for example, is that an investment trust company makes its money by buying and selling shares and securities in other companies, rather than through selling a specific product or service.

An investment trust company issues shares in itself, which is what an investor buys. These shares are generally only issued when the investment trust is created, which means the total number of shares available stays constant. This is known as being 'closed ended'.

The Association of Investment Companies (AIC) says there were 316 investment trusts in existence in the UK at the end of July 2007, worth around £95 billion, and this figure has grown steadily in recent years.

So what are the characteristics that set investment trusts apart from other collective investments? One feature unique to investment trusts, compared with vehicles such as unit trusts, is the way they are priced. If you take all the available shareholder funds in an investment trust - the company's assets less its liabilities - and divide it by the total number of shares in that company, you get the net asset value or NAV per share.

Supply and demand

Because investment trust companies are quoted on the stock exchange, the price of shares is determined by the stockmarket according to supply and demand and may not equal the NAV per share. This means they can be sold at a discount or a premium from that value.

"With a unit trust or an open-ended investment company (OEIC), the price of the fund is the same as the value of the underlying investment," says Patrick Connolly, certified financial planner at independent financial adviser firm Towry Law.

"That is not the case with an investment trust. The price of an investment trust depends on the demand for or supply of the investment trust, just like any other share. It depends on how much people are willing to pay for it and sell it for, so the price of an investment trust can be more or less than the net asset value."

This adds an extra level of complexity, because when an investor sells shares in an investment trust, the difference between the price paid for the share and the value of the underlying asset can increase or decrease. But James Saunders Watson, head of sales and marketing for investment trusts at JP Morgan Asset Management, says this offers opportunities when buying investment trust shares.

"We quite like getting clothes at a factory outlet," he says, "because it's cheaper than buying them on Bond Street. Similarly, it's nice to be able to buy £1 worth of assets for 90p, and that's what the discount enables you to do."

Lower charges

Costs vary between investment trusts, but are generally considerably lower than similar collective investments. That is because the board of directors is separate from the fund manager, so it can work to keep running costs low. Also, investment trusts do not pay commission to financial advisers or spend money on extensive marketing.

A typical unit trust can include an initial charge of less than 3% and an annual management charge of up to 1.5%. The total expense ratio (TER) on an investment trust, however, is generally much lower. On the average global growth investment trust, for example, it is less than 1%. However, charges can vary, and investment trusts with performance fees can be more expensive.

Sherry-Ann Sweeting, marketing manager of the Scottish Investment Trust, says: "Whatever the charges are, they are going to be very cost-effective compared to the typical unit trust."

Gearing up

An important factor that investors need to bear in mind with investment trusts is their ability to 'gear' or borrow money to invest. Alan Adam, financial consultant at Scottish IFA Alan Steel Asset Management, says: "If they're very positive about something, such as a particular stock that they believe is going to be a great story, they can borrow money and buy more of that stock, which works out well if they get the decision right."

But, while gearing can amplify the gains if markets are doing well, the reverse can happen, as Patrick Connolly explains. "The problem is that when you borrow money, you pay interest on that money to whoever you borrowed it from. If you invest it in an area that's going down - so the investment is going down in value - not only are you borrowing the money and paying interest on it, you've actually got more exposure to a falling market," he says.

Because of the extra risk - or opportunity - added by gearing and the fact that investment trust shares can sell at a discount or a premium, experts recommend holding your investment for the long-term. This gives you time to ride out any market fluctuations.

Pros and cons

"Investment trusts are an easy, cost-effective route to the stockmarket," Sweeting says. "They give diversity - some invest in tens, some invest in hundreds of companies, usually far more than the average investor could access - especially with areas like global growth, where you're investing across the world and across all market sectors." Sweeting also points out that with investments trusts, you have a team of experienced fund managers managing your money for relatively little cost.

Many investment trusts have saving schemes that let you put in as little as £50 a month, or even £25 in some cases. But because you pool your money with other investors, you benefit from economies of scale, keeping dealing and administration costs low.

Sweeting stresses the flexibility that investment trusts offer. Investors can invest monthly or in the form of a lump sum - or a combination of both - and they can start and stop investments as needed without penalty.

Wide appeal

A wide range of investors make use of investment trusts, from those dabbling in the stockmarket for the first time, through to more experienced investors. "Basically, whatever the investor, there's probably an investment trust to suit their requirements," says Sweeting. However, some IFAs believe that, because of their added complexities, investment trusts are better suited to the savvier investor.

You can buy shares in an investment trust through a stockbroker or financial adviser and also get access through an investment trust manager if it is an investment trust saving scheme or an individual savings account. You will have to pay fees to the adviser or stockbroker along with the normal stamp duty on buying shares, which is 0.5%.

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